Thursday, November 26, 2015

Economic capital is like pornography - you know it when you see it

There are two parts to this blog post. First the important stuff, clarifying the weirdness of capital and the confusion of applying economic concepts in practice. Second is a rant about where the weirdness and confusion comes from, and I point the finger at the intellectual laziness of the economics profession.

Important stuff
Read the below quote. Actually, read it twice. And think about it.
Genuine foreign investment, such as the building of factories and infrastructure, adds to the nation’s productive capacity and employment, and should be encouraged. By contrast, merely transferring ownership of an existing asset to foreign interests is akin to “selling the family jewels”. It does nothing to improve the economy and living standards, and should be discouraged.
This is from a recent post by top economic commentator Leith van Onselen at MacroBusiness. On the surface it makes sense. We want investment in new buildings, machines, infrastructure and equipment. And when foreigners want to makes those investments in Australia, that’s terrific.

But we don’t want to “sell the farm” to pay for it.

The thing is, net foreign investment in productive infrastructure, of machinery, building materials, and so forth of the type that Leith explains adds to our productive capacity, always exactly matches the net sale of domestic assets to foreigners.

The bold terms are crucial, for they reveal the accounting identity at the heart of the matter.

You see, capital account surpluses indicate that a nation sold more assets to foreigners than they bought foreign assets. A capital account surplus is balanced out by a current account deficits, which means that as a nation we imported more goods and services than we exported. Having a current account deficit requires selling assets to foreigners as payment for the net imports of goods and services which contribute to our capital stock.

As I said recently, the term foreign investment is “an idiotic and misleading term for a capital account surplus. It should be called balance of trading assets for goods and services.”

Capital in the external accounts is by definition not physical stuff. It is a set of institutionalised rights. Capital in economics, however, has been hijacked to mean physical stuff, which I show below provides very little guidance for answering important economic questions.

The rant
The blame for this confusion lies squarely with the economics profession. Not only do they routinely confuse the “capital” (K) in their models with capital in the common parlance used to describe funding and asset ownership arrangements, but they also think in terms of a world where there is no distribution or trade in asset ownership; all resource use is directed by a benevolent central planner.

At best capital is like pornography - ‘you know it when you see it’. In Christopher Bliss’s introductory comments to his book Capital Theory he notes
It is a fallacy to suppose that if we have a name for something there must be something, particularly a single something, which that name defines.
The textbooks are no help at all. In one textbook I have, by Frijters, Dulleck and Torgler, all I get is “physical capital includes machines, buildings, roads, harbours airports etc.”

Ricardo arguably began this tradition of capital as stuff stating that
Capital is that part of the wealth of a country which is employed in production, and consists of food, clothing, tools, raw materials, machinery, necessary to give effect to labour.
Or perhaps it was John Stuart Mill
What capital does for production, is to afford the shelter, protection, tools and materials which the work requires, and to feed and otherwise maintain the labourers during the process. These are the services which present labour requires from past, and from the produce of past, labour. Whatever things are destined for this use—destined to supply productive labour with these various prerequisites—are Capital.
Mankiw’s macroeconomics text has a similarly naive and brief definition, stating that capital “... is the set of tools that workers use: the construction worker’s crane, the accountant’s calculator, and this author’s personal computer.” And later, “the capital stock is the quantity of machines and structures available at a given time”.

The fundamental economic elements of capital seem to be:
  1. They must be produced physical objects that last a non-zero period of time 
  2. During that non-zero period of existence they must be an input into productive activity 
If that’s all there is to it then how can there be any non-capital goods produced? After all, food produced in one period is an input into the sustenance of productive labour in the next period. How can we walk around classifying objects as capital or consumption goods?

Look at the image below. A trained economist would call the bikes on the left consumption goods. But that same economist would turn around and call the ones on the right capital, since they are used as inputs into future production of bike hire services. Yet the ones on the left are also inputs into future cycling services as well! 

Where does that leave the core mainstream economic models? Say, the production function?

The equation below is typically used to introduce the idea of a production function, that say that output (Y) is a function of capital inputs (K) and labour inputs (L) in their strict physical economic definitions.

Y = f(K,L)

Yet if capital is everything except labour, then we can translate this equation to mean

“stuff produced is the product of labouring with other stuff”

Capital becomes merely a residual of inputs after labour (or is that just human capital?).

Once you are indoctrinated into the world of capital as physical objects, there is no where to go to explain deviations from your beliefs except in physical terms. If the model deals with physical stuff, changes in factor payments, wage levels and returns on ‘capital’ (which is quite clearly not physical stuff, since I've never seen a road or machine get paid), or even growth in output, must be the result of some mystical changes in the physical properties of stuff.

To explain these phenomena in this framework one must invoke the idea that objects have some special characteristic of being objects - a technology of objects - that allows them to transmogrify in particular ways that change their physical nature. Computers must compute more computely, and cars must drive more drively for growth to occur. And when these objects become more objecty they are then able to earn a higher ‘factor return’. Better computers bargain for better wages.

Economists are then naturally inclined to look for physical explanations of every social phenomena rather than institutional explanations. Maybe we are having a great stagnation, where objects are somehow unable to transmogrify as successfully anymore. Or maybe we are looking for physical answers to non-physical questions?

Problems with the physical object view arise in estimates of productivity (total factor or labour). The world of physical production is the fantasy world of the neoclassical production function. Some statistician is walking around pretending to measure physical quantities by looking at prices, classifying arbitrarily different objects into a stock of capital, pretending that the world rents every bit of capital from aliens, ignoring almost all the physical capital that is not in corporate accounts (like clouds, oceans, the atmosphere, mineral reserves) and stirring the Excel spreadsheet pot until a single number drops out.

When you read about the fall in Australia’s multi-factor productivity, you should laugh at the incoherence of everyone who pretends to know what it means, and feel sad of those who prescribe their own ideological remedy to the problem of a made up number going the wrong way.

You see, a negative change in multi-factor productivity is a puzzle for the production function view of the world. Does it mean we are so stupid that we combine stuff to make new stuff less effectively than we did last year? Are we getting dumber? Or is our stuff transmogrifying once again, and we are to blame the residual for our woes, and label it with the flavour of the month, like Hicks-Neutral technology shocks or something just as meaningless.

We can then say such profound nonsense as “computers made workers poor”. Okay.

Rant over.


  1. "Having a current account deficit requires selling assets to foreigners"

    That's again an economic misconception.

    A current account deficit merely requires foreigners to have saved the amount of your currency they have earned.

    There is no action required on behalf of actors in your country. You don't have to go out and get it. It happens as a result of there being a trade deficit *and it happens automatically at the same time*. If it doesn't happen *there can be no trade deficit* - the transactions will simply fail end to end because the entities couldn't get the right sort of money to complete the transaction (think the dry up in letters of credit).

    Foreigners tend to save deliberately to stop your currency going down and theirs going up - which would of course tend to stop the export stream to your country.

    It is simply a form of vendor financing.

    Classic economics is full of this sort of misconception. They believe governments have to wrench money from unwilling hands by 'borrowing' when in reality it is driven from the other side in a process more akin to depositing money in a bank. And they believe you have to force your money into foreigners hands, when in reality they happily take it and stuff it in the sock drawer in an international version of 'vendor financing' - all enabled by the liquidity processes in the banking system of the foreigners currency.

    Yet the classic assumption continue - like the religious beliefs they are.

    1. "A current account deficit merely requires foreigners to have saved the amount of your currency they have earned"

      What do you mean by saved? In the case of Australia for example, do you mean that foreigners have AUD in their banks? In that case that is an Aussie asset (money) sold to a foreigner, which has not returned to an Australian entity to purchase Australian goods and services (or was traded for a different Aussie asset).

      "There is no action required on behalf of actors in your country. You don't have to go out and get it. It happens as a result of there being a trade deficit *and it happens automatically at the same time*."

      I realise it is automatic and an accounting truth. But an accounting balance at the end of the day IS an outcome of actions by actors is it not?

      My question for you Neil. If a country running a large current account deficit enacted rather tight limits on both direct and indirect foreign ownership - of government bonds, of equities, of property and businesses etc - would this change the external balance? Would it change the exchange rate?

      Genuinely curious to see whether we strongly agree on the principles but are confused by each other's use of terminology.

  2. Well the capital account is now called the Financial Account by the IMF. Hopefully more people catch on and adjust.

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